U.S. Unlikely To Default. Investors Should Still Worry

A closed sign hangs at the entrance to the U.S. Treasury building in Washington D.C.

Bloomberg News

According to the markets, it’s vanishingly unlikely the U.S. defaults on its debt in any meaningful way. But that doesn’t mean the current political shenanigans won’t have a lasting impact on U.S. equities.

Yields on U.S. Treasury bonds have broadly fallen during the past month. Indeed, five-year T-bond yields are down 37 basis points in that time to 1.38%. That’s not a sign investors are expecting the government to renege on its obligations. For a salient contrast look at what Greek and Cypriot debt did a couple of years ago. Let’s not forget here it was the inability to pay due to lack of funds that caused the problems rather than a political impasse in the U.S.’s case.

Imagine trying to enforce these contracts in the event of a wholesale U.S. default. Rather they’re a thinly traded guide to sentiment. And sentiment says there’s only a very, very small possibility the U.S. defaults.

True, there’s a small chance that payment of some official obligations could be delayed, as they were during the U.S.’s technical default of 1979, which was caused by check-processing problems. But no one expects not to be paid. Only that they might get paid a little later than due.

So if a U.S. government default is a remote possibility, what’s the worry for equities?

Well, the fact that government spending has partially stopped will knock back growth. By one estimate a three-week shutdown should knock nearly a percentage point off U.S. gross domestic product in the current quarter. This loss, though, could be expected to be recovered later as spending is just postponed rather than cancelled.

In the wake of the financial crisis, the government’s decision to run huge deficits insulated the U.S. corporate sector. Between that and zero interest rates, corporate profits soared.

But since the government has started to pare back its deficit, profit growth has started to slow. Earnings are still expanding because households are borrowing to consume again. Borrowing, in turn, has been boosted by wealth effects, particularly a rebound in house prices but also equity prices.

But the impact of these wealth effects is likely to slow. Rising mortgage rates have already dented demand for houses, which is likely to constrain further house price growth. What could possibly boost house prices from here is wage growth, but wage growth would eat into corporate profits.

U.S. equities, meanwhile, have become very expensive. On a cyclically adjusted basis, they’re around 40% above historic norms. On a replacement cost basis, they’re about 50% overvalued. In either case, the upside seems limited.

So from here on in, any significant government deficit reduction is likely to feed through to profits more than it has hitherto. And corporate profits are already vulnerable.

U.S. corporate profits are at extremes. They are equivalent to some 10% of GDP, more than any previous cyclical peak since the Second World War and well above the 6% norm. History says they’re likely to shrink. This can happen in one of two ways. Profits can stay elevated and GDP can grow to fit. Or GDP can grow at the recent lackluster trend and corporate profits can fall.

Any serious contraction of government spending is unlikely to be accompanied by strong GDP growth. Which suggests profits are likely to come down. As they do, equities are likely to lose ground, hitting that part of the wealth effect and causing yet further downward pressure on earnings.

So equities may be right to shrug off the worst fears about U.S. government default–the S&P 500 is, after all, still within a couple of percentage points of its all-time highs. But their longer term prospects aren’t nearly as rosy as investors seem to believe.